The correlation between USD and oil prices

(28.02.2011) So far, turmoil in the Middle East has contributed to a strengthening of safe haven currencies. The exception has been the dollar, which has depreciated on a broad basis. We argue here that the dollar depreciation is likely attributable to the rise in oil prices. However, we expect the increase in oil prices to be temporary, which strengthen our view of a dollar appreciation going forward.

By Maren Romstad, Analyst at DNB Markets

illustration us dollarTurmoil in the Middle East has contributed to the strengthening of typical safe haven currencies, such as the Japanese yen and Swiss franc. But what about the US dollar? After the financial crisis, the dollar has been considered a safe haven currency and often strengthened during periods with decreasing risk appetite. This has not been the case lately and the dollar has depreciated on a broad basis.

To explain the development we take a closer look at a topic that received much attention during the summer of 2008, more specific the relationship between oil prices and the dollar exchange rate. Back then oil prices were record high, while the dollar was at a record low. The question then was whether there were fluctuations in the dollar that explained fluctuations in oil prices, or was it vice versa? At that time, we argued that the dollar moved oil prices and not the other way around.

Today, however, it is almost impossible to argue for the same relationship. But as we pointed out in 2008 the relationship can go both ways and is also something that can change over time. There are several arguments for why higher oil prices could result in a weaker dollar.

First, the US is a more energy-intensive economy and, hence, American households are relatively more vulnerable for increasing oil prices. This may be illustrated by how sensitive US consumer confidence is to changes in oil prices. Calculations show that the American consumer uses about 4 per cent of their disposable income on gasoline.
Second, different targets of monetary policy could play a role. The American central bank focuses more on core inflation than some other central banks, such as the ECB. During times when energy prices are high, overall inflation drives up, while core inflation is not as mush affected. Furthermore, this could result in an increase in the interest rate differential between the euro area and the US. In turn, this makes the dollar less attractive and can thus explaining the recent weakening of the dollar.

So far, however, this has not been as much debated as it was the summer of 2008. At that time there was a clearly self-reinforcing effect due to the great attention paid to the correlation. This could easily happen this time as well. Thus continued turmoil in the Middle East constitutes a risk to our view that the dollar should strengthen, especially in the short run. Longer term, we believe the rise in oil prices to be temporary, which strengthens our view of a dollar appreciation going forward. We are already expecting the US dollar to strengthen, due to relative growth and interest rate differences. A reversal of the latest increase in oil prices strengthens our view.

Yesterday the dollar continued to weaken, especially after a solid rise in oil prices in the morning. The movement may also have been reinforced by better-than-expected economic sentiment from the euro zone. Key figures from the euro area continue to surprise on the upside and points so far to a solid growth momentum in the first quarter.

Macro figures from the U.S., however, were on the weak side, and figures for new home sales and durable orders excluding transport orders disappointed relative to expectations. The number of initial claims was better than expected, but this was not enough to reverse the tendency in financial markets.

The turmoil in the Middle East also continues to affect Norwegian markets. Higher oil prices contributed to a stock market increase yesterday and the Norwegian krone remains strong. During yesterday NOK appreciated against the dollar, pound sterling and the Swedish krona.